The blogosphere is abuzz with reports of the dollar’s looming demise. The greenback has fallen against the euro by nearly 15 percent since the beginning of the summer. Central banks have reportedly slowed their accumulation of dollars in favor of other currencies. One sensational if undocumented story has the Gulf States conspiring with China, Russia, Japan, and France — now there’s an odd coalition for you — to shift the pricing of oil away from dollars.
Economists have no trouble explaining the dollar’s weakness after the fact. With American households saving more in order to rebuild their retirement accounts, the country has to export more. A weaker dollar is needed to make American goods more attractive to foreign consumers.
Moreover, disenchantment with the sophisticated instruments that US financial institutions specialize in originating and distributing means more limited foreign capital flows into the US. Fewer foreign purchases of US assets again imply a weaker dollar. Extrapolating the past into the future, forecasters predict that the dollar will decline further.
The first thing to say about this is that one should be skeptical about economists’ predictions, especially those concerning the near term. Our models are, to put it bluntly, useless for predicting currency movements over a few weeks or months.
I should know. When the sub-prime crisis erupted in early September 2007, I published an article titled “Why Now is a Good Time to Sell the Dollar” in a prominent financial publication. What happened next, of course, was that the dollar strengthened sharply, as investors, desperate for liquidity, fled into US Treasury securities. Subsequently the dollar did decline. But then it shot up again following the failure of Bear Stearns and the problems with AIG.
Over periods of several years, our models do better. Over those time horizons, the emphasis on the need for the US to export more and on the greater difficulty the economy will have in attracting foreign capital are on the mark. These factors give good grounds for expecting further dollar weakness.
The question is, Weakness against what? Not against the euro, which is already expensive and is the currency of an economy with banking and structural problems that are even more serious than those of the US. Not against the yen, which is the currency of an economy that refuses to grow.
Thus, for the dollar to depreciate further, it will have to depreciate against the currencies of China and other emerging markets. Their intervention in recent weeks shows a reluctance to let this happen. But their choice boils down to buying US dollars or buying US goods. The first option is a losing proposition.
In the longer run, OPEC will shift to pricing petroleum in a basket of currencies. It sells its oil to the US, Europe, Japan, and emerging markets alike. It hardly makes sense for it to denominate oil prices in the currency of only one of its customers. And central banks, when deciding what to hold as reserves, will surely put somewhat fewer of their eggs in the dollar basket.
Beyond this, the dollar isn’t going anywhere. It is not about to be replaced by the euro or the yen, given that both Europe and Japan have serious economic problems of their own. The renminbi is coming, but not before 2020, by which time Shanghai will have become a first-class international financial center. And, even then, the renminbi will presumably share the international stage with the dollar, not replace it.
The one thing that could precipitate the demise of the dollar would be reckless economic mismanagement in the US. One popular scenario is chronic inflation. But this is implausible. Once the episode of zero interest rates ends, the US Federal Reserve will be anxious to reassert its commitment to price stability. There may be a temptation to inflate away debt held by foreigners, but the fact is that the majority of US debt is held by Americans, who would constitute a strong constituency opposing the policy.
The other scenario is that US budget deficits continue to run out of control. Predictions of outright default are far-fetched. But high debts will mean high taxes. The combination of loose fiscal policy and tight monetary policy will mean high interest rates, sluggish investment, and slow growth. Foreigners — and residents — might well grow disenchanted with the currency of an economy with these characteristics.
Mark Twain, the nineteenth-century American author and humorist, once responded to accounts of his ill health by writing that “reports of my death are greatly exaggerated.” He might have been speaking about the dollar. For the moment, the patient is stable, external symptoms notwithstanding. But there will be grounds for worry if he doesn’t commit to a healthier lifestyle.
Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley.
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